Crash of 1998

Is it Over

Or Just Beginning?

By Martin A. Armstrong

Copyright September 9th, 1998

Princeton Economic Institute

There was a sigh of relief yesterday when the markets rebounded sharply. So many began to tout what stock should be bought right away that the Fed is thinking about lower interest rates instead of keeping its tight monetary policy. “It’s only a correction” hailed many as they emerged from the dark alleys and basements to which they sought refuge. Others were quick to proclaim that Japan’s 50% drop in interest rates from .5% to .25% marked the beginning of a concerted effort by several nations to respond to the crisis in the financial markets and now we should expect rate cuts from the US and Germany. Unfortunately, when we push aside the superficial analysis, hopes, dreams and sheer desperate expectations, the truth may be far from the salutations and praise.

To begin with, the rate cut in Japan is EXTREMELY BEARISH and in NO way should this be construed as a bullish move for the marketplace worldwide. For some time now, Japan has been printing yen notes like there is no tomorrow. They have even been reported as lending this cash to the banks at 0% interest. The rate cut of 50% will have a severely NEGATIVE impact upon the whole economy in Japan with the sole exception of the banking industry. This rate cut has merely increased the credit crunch that is expanding in Japan as banks refuse to lend money to any small to medium size firm while tightening the reins on major multinationals as well. This sudden and drastic 50% rate cut will have a major impact upon pension funds and corporates. We now find a sharp increase in corporate bond issues in Japan as companies fear that they could face a worsening credit crunch. In effect, this interest rate cut may in fact now seal the fate of a capital flight from Japan for next year and indeed may fulfill our long-term forecasts for the dollar/yen.

The policies in Japan are dangerously pushing the nation to the brink of massive deflation. We are becoming quite concerned that the losses within the Japanese banking system are massive and amount to at least 5 times or more than that of the US S&L Crisis. The general feeling from our Japanese sources is that the stimulus package will have no effect whatsoever upon the market over the next few weeks. If there is no lift, as we suspect, the government may collapse and a full general election called. Ultimately, we believe that the only course of action for Japan will be to monetize this entire problem. Our concern is that the longer this situation continues the greater overall damage to the non-banking sectors. Still, this interest rate cut reflects the stubbornness of the government, which still refuses to look at tax cuts. At this point, no amount of stimulus package will reverse the Japanese economy. The average Japanese is now frightened to see big banks and companies go down, which threaten’’ their traditional lifetime employment. This shocking social change in Japan, combined with persistent rumors of banks failures, means that no degree of stimulus package will have an effect upon the consumer until he feels confidence once again. Cutting the interest rate on what savings he now has will either cause the consumer to hoard his cash or export it to the United States.

The Russian crisis has still yet to show its full impact upon the world economy. Again, it is not trade that we should be concerned about but capital. The staggering losses taken by both banks and hedge funds has indeed caused havoc worldwide as both participants withdraw or sell off positions everywhere. We have seen the Nikkei rally on the bank hedge fund covering their shorts. We have seen the HK$ forward move sharply as liquidation orders came in from around the globe. We have seen metals collapse as Russian sales have included anything that is not nailed down. We have seen Latin American markets under siege and even the precious ERM pushed on Finland and Greece. Talk is now staring to surface about the postponement of the Euro as the Italian lira dropped causing intervention.

The world is still NOT a very friendly place for capital these days. We have little doubt that the Euro will go through January because this too is being orchestrated by politicians and not investors or economists. However, we do believe that the announced relationship between the currencies within the Euro will be revised by year-end perhaps on the last day. If this does NOT take place, kiss the Euro goodbye because the differentials between economies cannot possibly converge by January 1st, 1999. This will take even longer than the proposed transition of 4 years into 2002. The failure of the politicians in Europe to recognize the danger of diverting economies will only set the stage for the Euro to blow up in a similar manner as the fixed exchange rate mechanisms in South East Asia where pegs to the dollar failed. In the case of the Euro, it will be the peg of each currency to the Dmark that is now showing great stress.

It is of great concern that despite Allan Greenspan?s excellent grasp of history and respect for what took place during the Great Depression, we may not be able to avoid a repeat of history. However, UNDER NO CIRCUMSTANCES are we expecting a Great Depression in the sense of a 90% decline in the equity markets. Those days were quite different insofar as the world operated on a gold standard. If you didn?t have the gold, you defaulted. Today, we see that while the economic problems are similar to that of the Great Depression, the outcome is likely to be quite different involving a monetization as opposed to default. In other words, no major Western or Japan will announce to their public that they are defaulting on all welfare or social contracts. It is far more likely that they will attempt to monetize their way out and/or issue government bonds. The fact that Greenspan has hinted that he would cut rates “if necessary” suggests that indeed the world is looking at the possibility of monetization.

For this reason, we remain skeptical that even though our Economic Confidence Model has turned down into 2002.85, there may come a point by the half-cycle interval of 2000.70 (September 12th, 2000) that we actually see an intentional inflationary move that ultimately turns share back up! Immediately, many will say that we have totally lost it because stocks rise when inflation is low. In fact, the opposite is correct. Stocks rallied out of the 1932 low because people believed that Roosevelt would confiscate gold and devalue the dollar. That belief was correct. Roosevelt devalued the dollar by 69% in 1934 and stocks rallied into 1937. If you look at what has just happened in Malaysia, you see what stocks do when the currency is devalued. In this case, Malaysia has made its currency worthless in international circles. Under such conditions, how does one protect himself? The answer historically has been to purchase TANGIBLE assets. While some would like to argue that gold is the answer, this is simply NOT true! Yes, gold is ONE vehicle but NOT the only one! During the inflationary period of Germany, people sought to get rid of their currency for anything tangible as well as food. Thus, good shares have also acted as hedges against inflation because their assets rise in proportion to the devaluation of the currency. We also saw this take place in the UK following the pound’s withdrawal from the ERM when the FT100 moved higher in direct proportion to the percentage decline in the currency.

While there is little doubt that a breach of last week’s low in Europe and US share markets will cause a second decline of 30-40% (from major high), please refer to our daily reports for specific timing and price levels. The overall prospects remain pointing to a bear market moving into at least next year and possibly into 2000 before a change in trend materializes. We still see a further collapse in Russia and a major disruption in both Eastern Europe and Latin America before this event is over. We also see a Clinton resignation as inevitable along with a defeat of Kohl in Germany and a collapse in the Obuchi government in Japan. Those looking for someone to pull a rabbit out of the hat should not look to the Fed. While lowering interest rates by the Fed will help to reduce perhaps the magnitude of the overall decline – it will NOT reverse the trend back to new highs and prosperity for all!